Model Risk and Market Risk in Derivative Trading

Figlewski & Green (1999) develop a methodology to assess the model risk and market risk faced by a financial institution that follows two option-trading strategies: writing standard European options, pricing them by Black-Scholes model with volatilities forecasted from historical data, and carrying the position to expiration, either with or without delta hedging. Specifically, they try to examine the impact of volatility forecasting errors on returns and standard deviation of returns of above two trading strategies. The purpose of this paper is to test the robustness of this methodology. First, we replicated their methodology with the same S&P 500 data (Jan 1976-Dec 1991) used in the paper. Then we updated the results with recent S&P 500 data (Jan 1992- Dec 2003), and applied this methodology on NASDAQ with data from Jan 1992 to Dec 2003. Our robustness testing results indicate that Figlewski & Green‟s methodology is quite robust for different period and different market, since we can draw similar conclusions from our testing results.